The What, Why, How and When of Portfolio Rebalancing With Calculators to Boot

Beginning to invest for a long term goal in accordance with a plan is an important first step. Once the investing process is underway,

performance of the instruments chosen have to be monitored

the portfolio rebalanced

the goal plan re-evaluated annually and

a few years away from the goal-date a plan to shift funds from risky instruments to risk-free instruments should be in place.

Among these steps portfolio rebalancing is a concept not well understood by many. Let us first try to answer, why a long term investment portfolio should be monitored? This will naturally lead us to the idea of rebalancing. We will then look at the types of rebalancing and which among them is optimal.

Portfolios associated with long-term goals will/should have substantial equity component. Equity is a proven way of beating inflation over a long time. However investors must accept two aspects of equity investing:

Returns are volatile. You can get a return of +25% one year and -45% the next. If you stay invested for a long enough period the average return is likely to be above inflation. However volatility of returns can influence your final corpus amount. If you are investing for retirement, volatility can reduce the life of your retirement corpus (how long your money will last) by a good 2-3 years.

Sequence of returns.When, you enter the market can make a significant difference to the corpus you accumulate and how long your money will last when you are retired. A series of poor returns early in the investment tenure requires strong discipline to stay invested. A poor run towards the end of the investment tenure requires an immediate shift from equity to debt to minimize losses.

Therefore long term portfolios require constant monitoring. When you are accumulating a corpus, sequence of equity returns can be handled with disciple and prudence. Minimizing volatility of returns requires a little bit of know-how in addition to discipline.

Powers of compounding illustrations never mention anything about volatility! Presence of volatility implies that when returns exceed expectation some portion of it must be shifted to less volatile debt instruments. This safeguards the fruit of compounding since what goes up will come down. On the other hand what goes down will go up. So when returns turn negative we need the disciple to shift funds from debt instruments into equity. This enhances returns when they turn positive. Such periodic shifting of funds from equity to debt and vice versa is known as rebalancing. It is a process by which volatility is contained. If you had got a return of +25% in one year and immediately shifted some portion of your equity portfolio to debt then your loss would be lower if the next year return was -45%. Of course the gain would also be lower if it was +45% instead! That is a chance you will have to take. Rebalancing is a methodical way of ‘buying low and selling high’. Many define rebalancing as a way of realigning your portfolio to match your risk appetite. This is just one way of rebalancing. The correct and simplest definition: rebalancing refers to any means used to contain volatility in a portfolio.

How does one rebalance? What portion of funds do we shift? How often do we do it? There are many ways of rebalancing a portfolio. It is not tough to think of new ways once you get the hang of it. Here are a few popular ways:

Periodic Rebalancing: Let us say you start SIPs with 50% of what you can invest in equity and 50% in debt. A year later you inspect your portfolio. If it reads 45% equity and 55% debt you shift 5% from debt to equity. If it reads 60% equity and 40% debt you shift 10% from equity to debt. That is you shift funds such that the portfolio reads 50% equity and 50% debt at the start of each investment year. A detailed example of this can be found in the calculators.

Your equity and debt SIP amounts remain the same andare not part of this rebalancing exercise.

Initial asset allocation (example of 50:50 considered above) should match the goal profile (time frame and importance) and the risk appetite of the investor.

The above approach can be varied in many ways. You start with (equity)50:50 and instead of rebalancing to 50:50 each year you rebalance to say, 60:40 or to 45:55.

It is usual to do this annually. However it can be also done at any interval of choice. Every 6 months, every 2 years etc.

Threshold Rebalancing: Say you start with (equity) 50:50 and rebalance the portfolio back to 50:50 only if the equity component changes (increase or decrease) by, say 3% or 4% or 5%. That is, after year one if the portfolio reads 52:48 you do nothing. It reads 45:55 you do nothing. If it reads 56:44 or 40:60 you rebalance back to 50:50.

Here too the interval is variable. For example you rebalance only if the equity component changes each year by the threshold you set (3-5%). You can also do this every 6 months or even monthly.

The rebalancing can be also be made a one-way process. That is if equity gains by, say 5% you shift this excess to debt. If equity loses by 5% you do nothing.

Which is the best way to rebalance?

The calculators will help you decide that! Using historical Sensex and FD returns this is what I found:

Annual rebalancing is pretty efficient. For all possible 15 years periods between 1980 and 2011 the rebalanced portfolio was larger than the un-rebalanced one by an average 13%! This is for a 50:50 initial asset allocation. The difference will be higher if the equity portion is more.

Annual rebalancing is (typically) much more efficient than bi-annual or tri-annual rebalancing.

Annual rebalancing can make a retirement corpus last about 2-3 years longer.

Rebalancing makes a bigger difference in case of lump sum investments when compared to SIPs

Threshold rebalancing is also pretty impressive. For all thresholds bet. 1-5% and for the parameters as above (15 years and 50:50) the average was the same 13%. For other situations the threshold rebalancing outperformed annual rebalancing. You can use the calculators to find out.

Tax and exit loads are important factors while considering annual rebalancing. Threshold rebalancing is better since rebalancing occurs typically occurs once in 2-4 years depending on the threshold.

The threshold should be small. Anything more than 5% will decrease equity a little too much and affect compounding.

One-way rebalancing is a waste of time as it kills compounding.

Bottomline: Rebalancing should minimise volatility by safeguarding the fruits of compounding. Trouble is overdoing it will ruin compounding. So you need to strike a balance.

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I would prefer threshold rebalancing with a threshold of about 4-5%. Don’t take my word. Try out these rebalancing simulators and make your choice.

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About the Author

M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association.For speaking engagements write to pattu [at] freefincal [dot] com

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26 Comments

Not sure why. Save them and rename files as Rebalancing Simulator -Lite.xlsm and Comprehensive Rebalancing Simulator.xlsm I am sending the files to your email. Not sure if you will get them since they are macro enabled.

FA Magazine recently published a good primer on automated solutions for portfolio rebalancing. The article is titled The Last Frontier and was written by James Picerno and it is definitely well-researched. He managed to obtain quotes from industry experts such as Bill Winterberg, Joel Bruckenstein and Michael Kitces, all of whom I have tremendous respect for. The article is certainly a useful resource for any RIA or advisor interested in the basics of rebalancing. You can read my summary of the article here: http://wp.me/pPor1-Es

Thanks for sharing Craig. I will have a look at this and your site. I have interacted with Michael Kitces with regard to my bucket strategy simulator. It was very interesting to exchange notes on how different countries view retirement planning differently.

This is excellent. I will be trying out the calculators to backtest my own thresholds.

Just one confusion: surely the threshold should be higher to allow more compounding? You mention 5% or lower, but surely lower thresholds mean that equity is not allowed to gain more than 5% before you book the profits, thus killing a bull run quick, and fixed income is not allowed to gain more than 5% before you sell and buy equity, thus entering a bear run quite early? If the threshold is larger, say 20%, more money will compound in equity for the gain, while in a bear market, you will start to buy only when the bear market is well underway (or fixed income has comprehensively beaten equities, which is also a typical indicator of a good bear market).

Please correct me if I have gotten the mathematics wrong. We can test it using your calculator, as soon as I download & figure them out. Of course, the practical caveat with high thresholds is that you don’t want to distort your asset allocation too much, which is the primary function of rebalancing, with extra return being a nice byproduct.

Yes the threshold largely depends on market conditions. Play around with it in the calculator and you will get more insight. The downside of a large threshold is that if the market direction changes suddenly, you tend to lose out on the fruit of compounding. A 5% threshold seems to work in all market conditions giving steady benefit.

Hm yes, I confused 5% of total wealth with 5% of equity. The former is a threshold of 10%, which seems quite healthy.

I still can’t make sense of the fact that larger thresholds don’t work, even in a 20 year horizon of 1992 – 2011… That was an overall bull market for India and outstanding return with the usual high volatility. High thresholds should work. I do see a slight improvement with a 20% (10% on total wealth) threshold, but nothing like what I expected (1% more gain compared to the 5% on total wealth threshold).

I think it is the possibility that bubble values are not persisting for too long, while deep value also does not persist too long. If the calculator is using yearly returns of sensex, then perhaps a rolling monthly calculator would show greater rewards for higher thresholds.

Also I wonder what would happen with CNX 100 or Nifty data. Those indices are broader and capture the pain in the less favoured scrips at various points of time, and have become more representative since FII interest in India increased.

Hi Pattu, I make it a point to read all of your articles. Recently read your article on asset-allocation, now trying to implement it. Planning to start off with 60:40 equity:debt. My query is: being a govt employee, I have compulsory NPS. Should I regard it as pure debt, or should I note the fact that it has 15% equity component? Thanks, Kuntal.

I started reading the articles and really find it very intresting. Regarding the rebalancing, i do have one confusion. Please clear them

Supppose my Equity = 60% and Debt = 40% for first year and I need to keep it this way Second year it becomes 70% equity. Please suggest how do i rebalance. My investment are still continuing in form of monthly SIP

1. Should I sell my Equity and buy into Debt the sold amount OR 2. Should I rebalce my monthly SIP itself so that after say 2-3 months my portfolio comes near to 60:40which i need

The article is new thing to me and useful. I have one doubt. Say if I have taken few mutual funds and they already contain some equity part and some debt part. So should I consider each funds equity, debt part as seperate components? Or should I take them as their major component? How should I do rebalancing of my portfolio which has various mutual funds. Thankyou

Thank you for letting me know. I was able to do that and found only 7% is my debt part. Can anyone tell me if there will be 100% equity mutual funds and 100% debt mutual funds so that i can properly do rebalancing. Now its getting troublesome for how to do rebalancing.

Hi Pattu, Instead of re balancing, which is quite a task, can’t someone instead invest in Funds like HDFC balanace fund, or for that matter any good Hybrid fund which will do the hedge on behalf of us.

I am new in investment & planning to invest in direct mutual funds. I want some clear idea about rebalancing , suppose i start investing through SIP 10,000 in icici pru discovery & another 10,000 in UTI Equity Fund, then how i am to do rebalancing ….? i am going to invest only in equity sector . So for me what wuld you recommend.

Say a person has a Rs. 5000 sip in an equity fund and Rs. 5000 in a debt fund. Next year say the market is up by 10% and in the second year it is down by 10% then how do we balance the portfolio. Do you mean by shifting the Sip amount from equity to debt and vice versa?

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